Nirav B. Babu v. Commissioner , 2020 T.C. Memo. 121 ( 2020 )

T.C. Memo. 2020-121
UNITED STATES TAX COURT
NIRAV B. BABU, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
NIRAV BABU, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 8649-17, 20266-18.1 Filed August 17, 2020.
Gerald W. Kelly, Jr., Daniel S. Heller, Vadim D. Ronzhes, Derek W.
Kaczmarek, and David R. Jojola, for petitioner.
Richard J. Hassebrock, Evan K. Like, and Gary R. Shuler, Jr., for
respondent.
1
Nirav B. Babu and Nirav Babu are the same person. We consolidated these
cases for trial, briefing, and opinion by order dated July 23, 2019.
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[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
LAUBER, Judge: With respect to petitioner’s Federal income tax for 2013
and 2014, the Internal Revenue Service (IRS or respondent) determined deficien-
cies and accuracy-related penalties as follows:
Year Deficiency Penalty
2013 $338,752 $67,750
2014 7,030,829 1,406,166
For 2013 petitioner has conceded all of the adjustments including the
penalty, subject to respondent’s concession that he is entitled to an additional
deduction of $79,500 from Schedule C, Profit or Loss From Business. For 2014
the parties have both made numerous concessions, including concessions by
respondent that eliminated unreported income adjustments exceeding $14 million.
The parties’ concessions are set forth in a joint stipulation of settled issues filed
October 16, 2019, which is incorporated by this reference.
Particularly relevant for this opinion are petitioner’s concessions that Re-
funds Plus, LLC, a passthrough entity of which he was the sole member, had gross
receipts of $2,819,433 for 2014 and that he failed to report on Schedule E, Supple-
mental Income and Loss, $2,908,220 of flow-through income from that entity.
The sole question remaining for decision is whether that failure generates an
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[*3] accuracy-related penalty for an underpayment attributable to a substantial
understatement of income tax. See sec. 6662(a), (b)(2), (d)(1).2 We resolve this
question in respondent’s favor.
FINDINGS OF FACT
The parties filed multiple stipulations of facts with accompanying exhibits
that are incorporated by this reference. Petitioner resided in Maryland when he
filed his petitions.
After earning a B.A. degree in finance petitioner attended law school at the
University of Baltimore, graduating in 2005. During law school he took courses
in tax law, participated in a tax clinic that assisted low-income taxpayers, and fin-
ished “with a pretty good understanding of tax.” In 2006 he became licensed to
practice law in three jurisdictions and maintained those licenses through 2013.
During law school petitioner was employed by Instant Tax Services (ITS),
which at the time was one of the largest tax return preparation firms in the country.
He assisted Fesum Ogbazion, the owner of ITS, in opening four ITS stores in the
Baltimore area. During law school petitioner served as area manager for those
locations, and after graduating he served for five years as general counsel for ITS.
2
All statutory references are to the Internal Revenue Code (Code) in effect at
the relevant times, and all Rule references are to the Tax Court Rules of Practice
and Procedure. We round all monetary amounts to the nearest dollar.
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[*4] ITS operated on a franchise basis, supplying store owners with software that
they used to prepare and process returns. While serving as ITS’ general counsel
petitioner began acquiring ITS franchises, and by 2013 he held franchises for 19
separate ITS locations. These franchises were profitable, netting aggregate profits
exceeding $800,000 for petitioner during 2008-2010.
In March 2012 the U.S. Department of Justice (DOJ) filed a civil complaint
against ITS, Ogbazion, and related entities seeking to enjoin them from “engaging
in and facilitating extensive and pervasive tax fraud.” A two-week trial was held
before the U.S. District Court for the Southern District of Ohio in July 2013. On
November 6, 2013, that court permanently enjoined Ogbazion and ITS from en-
gaging in any business involving the preparation or filing of Federal tax returns.
Petitioner regarded Ogbazion as a close friend and mentor. Although peti-
tioner was not a named defendant in the injunction case, he was singled out in the
court’s opinion as having been complicit in the abusive conduct in which ITS en-
gaged. This conduct included assisting Ogbazion in concealing $5 million in a
secret bank account to avoid creditors.
Because of petitioner’s close association with Ogbazion, the DOJ would not
approve any arrangement that enabled petitioner to take over the tax preparation
business formerly conducted by ITS. That business was taken over by Great Tax,
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[*5] LLC (GTX), a new tax preparation firm wholly owned by John Mirlisena.
Many store owners that had been ITS franchisees signed up with GTX, offering to
consumers tax preparation services similar to those that ITS had previously
provided.
In December 2013, roughly a month after the court issued its injunction
against ITS, petitioner formed and became the sole member of Refunds Plus, LLC
(RP), an S corporation for Federal tax purposes. Petitioner acquired from Ogba-
zion and made available to RP the tax processing software that ITS had previously
used. During 2014 RP provided services to GTX by using this software to process
tax returns for GTX customers, most or all of whom expected refunds.
Mr. Mirlisena agreed that RP would be paid a fee of $100.95 for each GTX
return that it processed claiming a refund. In many such cases the customer re-
ceived a “refund loan” from GTX. In that event RP’s processing activity included
dividing the tax refund (once received from the IRS) into “buckets” corresponding
to the sums due GTX (for repayment of the loan), RP (for its $100.95-per-return
fee), the store owner (for its fee), and the taxpayer (if anything was left over). Be-
cause the fees due RP were segregated into a separate “bucket,” petitioner was
aware at all times of the amounts that GTX owed RP.
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[*6] Petitioner opened bank accounts for RP, but they showed little activity dur-
ing 2014.3 However, on January 2, 2014, petitioner and Mr. Mirlisena executed
deposit account control agreements that authorized petitioner to withdraw cash
from GTX’s bank accounts. Petitioner was permitted access to any GTX account
and did not need to secure consent from GTX or Mr. Mirlisena before making
withdrawals. Exercising this authority petitioner wired well over $3 million out of
GTX’s bank accounts, to himself and others, during 2014.4
Petitioner maintained no formal books or records tracking RP’s income and
expenses during 2014. During that year RP processed almost 30,000 returns for
GTX and thereby earned a fee of $100.95 per return. On its 2014 Federal income
tax return RP checked the box electing the cash basis of accounting and reported
that it had zero gross receipts. The parties now agree that RP during 2014 in fact
had gross receipts of $2,819,433 from GTX and that petitioner failed to report, on
his individual return, $2,908,220 of flow-through income from RP.
3
RP had four bank accounts. Two had no activity during 2014, and the
other two had aggregate deposits of $18,000.
4
The record shows that these withdrawals were very substantial, but does
not establish the exact amount. In subsequent litigation (eventually settled) Mr.
Mirlisena averred that petitioner had withdrawn about $17.5 million from GTX’s
bank accounts during 2014.
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[*7] In February 2017 and July 2018 the IRS issued petitioner timely notices of
deficiency for 2013 and 2014, respectively.5 He timely petitioned with regard to
each notice. On October 16, 2019, the parties filed a stipulation of settled issues
resolving all issues but one--whether petitioner is liable for an accuracy-related
penalty with respect to the portion of the 2014 deficiency attributable to his failure
to report flow-through income from RP. See sec. 6662(b)(2). He contends that he
relied on professional advice as to the proper reporting. Alternatively he contends
that, because RP received no payments directly from GTX during 2014, he reason-
ably concluded that RP, as a cash basis taxpayer, had no gross receipts.
At trial we heard testimony from petitioner, Mr. Mirlisena, Arun Chawla
(petitioner’s return preparer), and Chelsea Rebeck (an accountant and attorney
with whom petitioner had business dealings). Mr. Mirlisena credibly testified that
petitioner, pursuant to the deposit account control agreements, was authorized to
withdraw from GTX’s bank accounts--and did withdraw during 2014--amounts
comfortably exceeding the fees that RP was owed for the return-processing ser-
vices it furnished GTX.
5
Petitioner filed joint returns for both years; his wife separately contested
her liability and is not a party to these cases.
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[*8] Mr. Chawla prepared the 2014 returns for petitioner and RP, and those re-
turns were filed on August 6 and August 20, 2015, respectively. Mr. Chawla and
his staff prepared these returns on the basis of the information petitioner gave
them. Mr. Chawla did not review petitioner’s own bank accounts or books and
records. He did not question petitioner’s representation that RP had no gross
receipts, noting that RP was a new company with bank accounts that showed
minimal activity. Petitioner did not inform Mr. Chawla that RP had processed
almost 30,000 returns for GTX during 2014, that RP had charged a fee of $100.95
per return, or that petitioner had withdrawn well over $3 million from GTX’s bank
accounts during 2014.
Ms. Rebeck obtained a law degree in 2012 and had been practicing law full
time for less than a year as of August 2015. Petitioner hired Ms. Rebeck to repre-
sent him in a dispute with the IRS involving the assessment of penalties for al-
leged violation of section 6695(g), which requires return preparers to exercise due
diligence regarding claims for the earned income credit. On September 7, 2015,
she filed a Form 2848, Power of Attorney and Declaration of Representative, to
represent him before the IRS in that matter.
Ms. Rebeck and petitioner testified that she also provided him with tax ad-
vice--before Mr. Chawla filed petitioner’s and RP’s returns in August 2015--that
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[*9] RP was not required to report any gross receipts for 2014. We did not find
either’s testimony on that point credible. Petitioner’s testimony was self-serving,
and Ms. Rebeck did not strike the Court as an objective or candid witness.
Petitioner and Ms. Rebeck had mutual business interests, insufficiently ex-
plained, that involved large sums of money. Ms. Rebeck acquired former ITS
franchises that appeared to have used RP’s software to process returns. In 2015
she and petitioner started a law firm whose bank account balances exceeded $3.8
million by January 2016. In early 2018 petitioner transferred $500,000 to Ms.
Rebeck for unexplained reasons. At some point she transferred to petitioner a
99.9% interest in an LLC for no consideration. Petitioner and Ms. Rebeck were
codefendants in a lawsuit filed in 2019 involving alleged misappropriation of
funds. For these and other reasons, we found that Ms. Rebeck’s testimony was
likely to be biased in petitioner’s favor.
There was no documentary evidence to support Ms. Rebeck’s testimony that
she gave petitioner timely advice about the positions taken on his and RP’s 2014
returns. She supplied no evidence of letters, memos, or emails--dated before those
returns were filed--in which she advised petitioner about the reporting of RP’s
gross receipts. She supplied no billing records documenting any tax preparation
work performed for petitioner or RP before August 2015. There is no evidence
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[*10] that Ms. Rebeck devoted substantive attention to the question of RP’s gross
receipts until after the IRS selected the 2014 returns for examination.
Petitioner’s and RP’s returns for 2014 were prepared by Mr. Chawla and his
staff, not by Ms. Rebeck. There is no evidence that Ms. Rebeck communicated
with Mr. Chawla or any member of his staff about those returns before they were
filed. There is no evidence that petitioner informed Mr. Chawla or his staff that he
had received tax advice from Ms. Rebeck or (if he had) what that advice was.
OPINION
The sole question we must decide is whether petitioner is liable for an ac-
curacy-related penalty on account of his failure to report $2,908,220 of flow-
through income from RP for 2014. Section 7491(c) generally provides that “the
Secretary shall have the burden of production in any court proceeding with respect
to the liability of any individual for any penalty.” This burden requires the Com-
missioner to come forward with sufficient evidence indicating that imposition of
the penalty is appropriate. See Higbee v. Commissioner, 116 T.C. 438, 446
(2001). Once the Commissioner meets this burden, the burden of proof is on the
taxpayer to “come forward with evidence sufficient to persuade a Court that the
Commissioner’s [penalty] determination is incorrect.” Id. at 447.
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[*11] The Code imposes a 20% penalty upon the portion of any underpayment of
tax that is attributable to (among other things) “[a]ny substantial understatement of
income tax.” Sec. 6662(a), (b)(2). An understatement of income tax is “substan-
tial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown on
the return. Sec. 6662(d)(1)(A). Petitioner concedes that he failed to report
$2,908,220 of flow-through income from RP for 2014. The record shows (and
petitioner does not dispute) that the understatement of income tax attributable to
this failure (and to the other adjustments petitioner has conceded) exceeds $5,000
and 10% of the total tax required to be shown on his return. Respondent has thus
carried his burden of production to show a “substantial understatement of income
tax.” See sec. 7491(c).
The Commissioner’s burden of production under section 7491(c) also in-
cludes establishing compliance with section 6751(b), which requires timely super-
visory approval of penalties. See Chai v. Commissioner, 851 F.3d 190, 217, 221-
222 (2d Cir. 2017), aff’g in part, rev’g in part T.C. Memo. 2015-42; Graev v.
Commissioner, 149 T.C. 485 (2017), supplementing and overruling in part 147
T.C. 460 (2016). The record reflects and petitioner concedes that the IRS secured
timely supervisory approval for the penalties determined in the 2014 notice of
deficiency.
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[*12] The section 6662 penalty does not apply to any portion of an underpayment
“if it is shown that there was a reasonable cause for such portion and that the tax-
payer acted in good faith with respect to * * * [it].” Sec. 6664(c)(1). The decision
as to whether the taxpayer acted with reasonable cause and in good faith is made
on a case-by-case basis, taking into account all pertinent facts and circumstances.
Sec. 1.6664-4(b)(1), Income Tax Regs. Circumstances that may signal reasonable
cause and good faith “include an honest misunderstanding of fact or law that is
reasonable in light of all of the facts and circumstances, including the experience,
knowledge, and education of the taxpayer.” Ibid.
Reasonable cause can be shown by good-faith reliance on the advice of a
qualified tax professional. Sec. 1.6664-4(b)(1), (c), Income Tax Regs. To estab-
lish this defense the taxpayer must prove that: (1) the adviser was a competent
professional who had sufficient expertise to justify reliance, (2) the taxpayer fully
disclosed all relevant facts to the adviser, and (3) the taxpayer actually relied in
good faith on the adviser’s judgment. Neonatology Assocs., P.A. v. Commission-
er, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
Petitioner does not contend (and could not plausibly contend) that he relied
on advice from Mr. Chawla regarding the proper reporting of RP’s gross receipts.
Mr. Chawla performed no independent evaluation of this question; he simply re-
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[*13] ported the figures that petitioner gave him. Petitioner did not inform Mr.
Chawla that RP had processed almost 30,000 returns for GTX during 2014, that
RP charged a fee of $100.95 per return, or that he had withdrawn well over $3
million from GTX’s bank accounts during 2014. Petitioner obviously did not fully
disclose all relevant facts to Mr. Chawla. See ibid.
Petitioner contends that he relied on advice from Ms. Rebeck regarding the
reporting of RP’s gross receipts. We find this argument deficient for a number of
reasons. On the whole, Ms. Rebeck was not a credible witness, and her financial
entanglements with petitioner raised serious questions about her objectivity. See
106 Ltd. v. Commissioner, 136 T.C. 67, 79 (2011) (“[A]dvice must generally be
from a competent and independent advisor unburdened with a conflict of inter-
est[.]” (quoting Mortensen v. Commissioner, 440 F.3d 375, 387 (6th Cir. 2006),
aff’g T.C. Memo. 2004-279)), aff’d, 684 F.3d 84 (D.C. Cir. 2012).
The theories that Ms. Rebeck offered at trial to justify not reporting RP’s
gross receipts were implausible. She suggested that the money petitioner with-
drew from GTX’s bank accounts reflected repayments of loans he had made per-
sonally to GTX, rather than payments of return-processing fees that GTX owed
RP. But she could point to no evidence documenting the purported loans. Ms.
Rebeck alternatively suggested that RP did not have to report any gross receipts
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[*14] because it had supposed bad debt deductions exceeding its gross receipts.
She offered no legal or factual support for that theory. All in all, Ms. Rebeck’s
testimony raised serious questions as to whether she was “a competent
professional who had sufficient expertise to justify reliance.” Neonatology
Assocs., 115 T.C. 99.
In any event, we found no credible evidence, documentary or testimonial,
that Ms. Rebeck supplied tax advice regarding the reporting of RP’s gross re-
ceipts, to petitioner or Mr. Chawla, before petitioner’s and RP’s 2014 returns were
filed in August 2015. She supplied no letters, memos, or emails addressing this
subject that were dated before August 2015, and she supplied no billing records
documenting any tax preparation work done for petitioner or RP before August
2015. There is no evidence that Ms. Rebeck devoted substantive attention to the
question of RP’s gross receipts until after the IRS selected the 2014 returns for
examination. The theories she enunciated at trial struck the Court as post hoc
rationalizations for petitioner’s erroneous reporting.
Putting aside any purported tax advice, petitioner contends that he believed
it reasonable to report RP as having no gross receipts because RP was a cash basis
taxpayer that received no payments directly from GTX during 2014. As a con-
dition of performing return-processing services for GTX, however, petitioner
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[*15] insisted that Mr. Mirlisena execute deposit account control agreements
enabling petitioner to withdraw cash from GTX’s bank accounts. Exercising this
authority petitioner wired well over $3 million out of GTX’s bank accounts, to
himself and others, during 2014. That sum comfortably exceeded the amount that
RP was owed for processing almost 30,000 tax returns for a fee of $100.95 per
return.
Petitioner was a lawyer with at least seven years of intensive experience in
the business of preparing Federal income tax returns. By his own admission he
emerged from law school “with a pretty good understanding of tax.” His argu-
ment, in essence, is that RP had no gross receipts because he, as RP’s sole mem-
ber, deposited directly into his bank accounts the fees that RP was owed for the
services it performed. We do not believe that petitioner actually misunderstood
the tax law that makes this argument a nonstarter. It is obvious and well estab-
lished that a shareholder cannot avoid current taxation by diverting a company’s
gross receipts to himself. See, e.g., DiLeo v. Commissioner, 96 T.C. 858, 883-885
(1991) (finding shareholders liable for tax when they deposited a portion of their
corporation’s gross receipts into secret bank accounts), aff’d, 959 F.2d 16 (2d Cir.
1992). But assuming arguendo that he did, we find that his misunderstanding was
not “reasonable in light of all of the facts and circumstances,” including his
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[*16] experience, education, and knowledge of tax law. See sec. 1.6664-4(b)(1),
Income Tax Regs.
For these reasons, we find that petitioner has failed to carry his burden of
demonstrating reasonable cause for his failure to report $2,908,220 of flow-
through income from RP for 2014. We accordingly hold that he is liable for an
accuracy-related penalty with respect to the portion of his underpayment attribut-
able to that failure.6
To reflect the foregoing,
Decisions will be entered under Rule
155.
6
Petitioner does not dispute that he is liable for an accuracy-related penalty
with respect to the portion of the underpayment attributable to the other 2014
adjustments that he has conceded.